What is Menu Costs
Menu costs refer to an economic term used to describe the cost incurred by firms in order to change their prices. How expensive it is to change prices depends on the type of firm. For example, it may be necessary to reprint menus, update price lists or re-tag merchandise on the shelf. Even when there are few apparent costs to changing prices, changing prices may make customers apprehensive about buying at a given price, resulting in a menu cost of lost sales.
BREAKING DOWN Menu Costs
The net result of menu costs is that prices are sticky. That is to say, firms are hesitant to change their prices until there is a sufficient disparity between the firm's current price and the equilibrium market price. In theory, a firm should not change its price until the price change will result in enough additional revenues to cover the menu costs. In practice, however, it may be difficult to determine the equilibrium market price or to account for all menu costs, so it is hard for firms and consumers to behave precisely in this manner.
History of the Menu Costs Concept
The concept of menu costs was originally introduced by Sheshinski and Weiss in 1977. The idea of applying it as a general theory of nominal price rigidity was simultaneously put forward by several New Keynesian economists from 1985 to 1986. George Akerlof and Janet Yellen, for example, put forward the idea that due to bounded rationality, firms will not want to change their price unless the benefit is more than a small amount. This bounded rationality leads to inertia in nominal prices and wages which can lead to output fluctuating at constant nominal prices and wages.
There is debate over whether menu costs are truly large enough to cause business cycles. However, there is empirical evidence from studies that menu costs are indeed large enough to cause business cycles. In one study, store-level data from five multi-store supermarket chains was examined to directly measure menu costs. The study found that menu costs per store averaged more than 35 percent of net profit margins – indeed large enough to have macroeconomic significance. Furthermore, studies found that menu costs may cause considerable nominal rigidity in other industries or markets, thus amplifying the effects on business cycles. These menu costs can vary largely due to local regulations, which may require, for instance, a separate price tag on each item, thus increasing menu costs.